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Morningstar | National Australia Bank Increases Customer Remediation Costs. FVE AUD 32 Unchanged

Wide-moat National Australia Bank announced AUD 314 million in aftertax costs for customer remediation matters, just prior to CEO Andrew Thorburn’s turn in front of the Parliamentary Standing Committee on Economics on Oct. 19, 2018. The bank had flagged unspecified additional remediation costs with the release of the third-quarter trading update in mid-August. The remediation costs will reduce our fiscal 2018 cash earnings forecast by AUD 261 million with earnings from discontinued operations reducing by approximately AUD 53 million. The additional costs are excluded from management expense growth guidance of 5%-8% for fiscal 2018.

The AUD 314 million in additional costs include three unquantified key elements. Refunds and compensation to customers in the wealth business, covering advisor service fees, plan service fees, wealth advice reviews and other wealth-related issues, is the major contributor. Costs incurred in implementing the remediation processes and costs associated with regulatory compliance make up the balance. Further details are expected with the release of full-year results on Nov. 1, 2018. Costs associated with responding to the Royal Commission are not included in the provision. Disappointingly, the program of customer remediation and reviews is expected to continue into 2019 with the potential for further costs to be recognised in fiscal 2019.

The customer refunds and compensation assessments were prompted by the reputation-damaging Royal Commission, and we are disappointed the bank had not more promptly identified and resolved these serious breaches of customer trust. Nonetheless, the AUD 261 million provision is immaterial to profit from ongoing operations and our positive long-term view is intact. National Australia Bank is trading at an attractive 20% discount to our AUD 32 fair value estimate and despite the embarrassment in recognising additional customer remediation costs, we maintain our Standard stewardship rating.

Shareholder capital has not been significantly damaged or impaired and we think the bank is in a good position to sell, demerge or separate the scandal-plagued MLC Wealth business by the end of calendar 2019. National Australia Bank recently appointed ex CEO of Perpetual Limited, Geoff Lloyd, as head of MLC Wealth. MLC reported a first-half fiscal 2018 pro forma cash NPAT of approximately AUD 102 million.

National Australia Bank estimates approximately 69% of the AUD 261 million will be treated as negative revenue with 31% reported as additional expenses. We reduce our fiscal 2018 cash earnings forecast to AUD 6.15 billion from AUD 6.45 billion previously to reflect the higher costs. To account for ongoing remediation work and Royal Commission costs we reduce our fiscal 2019 cash earnings forecast to AUD 6.7 billion from AUD 6.8 billion previously.

Before the announcement of the additional charges and refunds, consensus estimates from continuing operations for fiscal 2018 cash earnings were AUD 6.0 billion, including the AUD 530 million aftertax restructuring provision, and AUD 6.77 billion for fiscal 2019.

The bank's remediation costs are tracking in line with major peers. Australia and New Zealand Banking Group announced customer refunds and compensation costs of AUD 374 million aftertax on Oct. 8, 2018 and Westpac announced a AUD 235 million aftertax provision on Sept. 27, 2018.

Our forecast fully franked dividends for fiscal 2018 and fiscal 2019 of AUD 1.98 per share are unchanged, as we expect the payout ratio to increase to 90% and 83%, respectively. At current prices, the fiscal 2018 forecast dividend yield of 7.8%, grossed up to 11%, provides some valuation support, but negativity around the Royal Commission and an expected tougher regulatory environment continue to weigh on the stock price. The current one year forward price/earnings ratio of 10 times remains well below the five-year average of just under 12 times.

Despite the increase in provisions, organic capital levels continue to build, and we anticipate no problems in the bank achieving the regulator's definition of "unquestionably strong" by the January 2020 deadline. The bank’s common equity Tier 1 capital ratio was 9.7% at June 30, 2018. We expect the key capital ratio will be around 10.2% at Sept. 30, 2015 and will comfortably achieve the 10.5% regulatory benchmark by January 2020.